February 3, 2022
Final regulations treat domestic partnerships as aggregates for applying certain subpart F provisions, and proposed regulations would apply a similar approach to PFICs
On January 25, 2022, the US Treasury Department and the Internal Revenue Service published final regulations (T.D. 9960) treating domestic partnerships as aggregates (i.e., not as entities) for many subpart F purposes. These regulations finalize, with limited changes, regulations originally proposed in 2019 (See Tax Alerts 2019-1132 and 2019-1185.)
Proposed regulations (REG-118250-20) also were issued that would extend the aggregate treatment of domestic partnerships to a "passive foreign investment company" (PFIC). These final and proposed regulations are relevant to any domestic partnership owning stock in a foreign corporation. S corporations generally are treated like domestic partnerships for the purposes of these final and proposed regulations.
Previously, a domestic partnership or S corporation that was a "United States shareholder" as defined in IRC Section 951(b) (US Shareholder) of a "controlled foreign corporation" (CFC) computed a subpart F inclusion at the entity level and included that amount in the distributive shares of all partners. The final regulations provide that a partner of a domestic partnership or S corporation that owns stock in a CFC will have a subpart F income inclusion only if that partner is, in its own right, an indirect US Shareholder of the CFC.1 The rule for subpart F inclusions now matches the GILTI inclusion rule for partners of domestic partnerships, and shareholders of S corporations, that own CFCs.
The proposed regulations concern domestic partnerships and S corporations that own stock in a PFIC for which a "qualified electing fund" (QEF) or "mark-to-market" (MTM) election could be made. Currently, only the domestic partnership or S corporation (and not the partners or S corporation shareholders) can make these elections. The proposed regulations would reverse the current rule so that only the partners or S corporation shareholders — not the partnership or S corporation — could make the elections. The proposed regulations would also substantially increase the number Forms 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, that would have to be filed.
A US person or entity that directly, indirectly or constructively owns at least 10%, by vote or by value, of a foreign corporation is a US Shareholder of the corporation. If more than 50% by vote or by value of a foreign corporation is directly, indirectly, or constructively owned by US Shareholders, then the foreign corporation is a CFC. Each US Shareholder of a CFC must generally include in income its pro rata share of certain categories of the CFC's income (a subpart F income inclusion) or the CFC's investment in US property ( an IRC Section 956 inclusion). A domestic partnership or S corporation historically has been treated as an entity for purposes of determining whether a foreign corporation is a CFC; in contrast, a foreign partnership is treated as an aggregate of its partners for this purpose.
The final regulations subject a partner of a domestic partnership or shareholder in an S corporation to a subpart F income inclusion or an IRC Section 956 inclusion only if the partner or S corporation shareholder is a US Shareholder of the underlying CFC. Thus, a partner of a domestic partnership or S corporation shareholder that is not a US Shareholder of the underlying CFC will not have a subpart F inclusion with respect to that CFC.
Although the final regulations apply the aggregate treatment to "grantor trusts" (IRC Sections 671-679), they apply the entity treatment to domestic non-grantor trusts or domestic estates. Accordingly, a domestic non-grantor trust or domestic estate would continue to determine subpart F inclusions at the trust or estate level, which may be taxable to the beneficiaries of the domestic trust or estate if that amount is included in the beneficiaries' distributive share of trust or estate income.
The final regulations retain the entity approach to domestic partnerships for purposes of IRC Section 1248. Thus, gain recognized by a domestic partnership from the sale of a CFC's stock may still be subject to IRC Section 1248 even though none of its partners are US Shareholders. Similarly, the final regulations continue to treat a domestic partnership or S corporation as a US person for purposes of determining whether a CFC holds US property (e.g., debt issued by a domestic partnership that is held or guaranteed by a CFC) for purposes of applying IRC Section 956.
Currently, domestic partners of a domestic partnership or S corporation shareholders are not required to file Form 5471, Information Return of US Persons With Respect To Certain Foreign Corporations, if (1) the domestic partnership or S corporation is a US Shareholder of a CFC, and (2) the domestic partnership or S corporation files the form.2 The final regulations do not change this result. Thepartners or S corporation shareholders should be able to obtain the necessary information to compute their subpart F inclusions (if any) using the Schedule K-3 provided by the partnership or S corporation (See Tax Alert 2020-1851.)
The final regulations apply to foreign corporations' tax years beginning on or after January 25, 2022, and to tax years of US persons in which or within which those tax years end. As previously announced by Treasury and the IRS, a domestic partnership may elect to apply these regulations to foreign corporations' tax years beginning after 2017, and to tax years of US Shareholders in which or within which those tax years end, subject to a consistency requirement for related partnerships.
Other corollary issues, e.g., PFICs, treatment of S corporations, and application of the net investment income tax (NIIT) under IRC Section 1411, are addressed, at least in part, in proposed regulations and discussed later. Although the Preamble acknowledges issues regarding a CFC's previously taxed earnings and profits (PTEP) when the domestic partnership is treated as an aggregate, those issues are left to future guidance.
Proposed PFIC rules
A foreign corporation is a PFIC if it has either (i) passive income or (ii) assets that produce passive income above certain thresholds. Distributions from a PFIC may be, and gain from the sale of PFIC shares is, subject to a regime designed to eliminate any benefit from the deferral of the PFIC's undistributed earnings. A QEF election, however, prevents the application of that regime, at the cost of annual inclusion of the PFIC's earnings. An MTM election also prevents application of that regime by deeming a shareholder to have sold all its PFIC shares annually. Currently, both elections are made by the first domestic partnership or S corporation in the PFIC's chain of ownership.
Generally, direct and indirect shareholders in a PFIC must file Form 8621. If a domestic partnership or S corporation files the form for a PFIC, however, its partners (and indirect shareholders of the PFIC) need not file the form for that PFIC.
The proposed regulations would treat domestic partnerships and S corporations owning PFICs as aggregates with respect to their PFIC ownership. This has several consequences. Only partners and shareholders, not their domestic partnerships and S corporations, would make QEF or MTM elections for PFICs owned by the partnerships or S corporations. As such, partners and shareholders that make the QEF or MTM elections would have to separately file Form 8621with respect to the PFICs owned by their domestic partnerships and S corporations (except for partners and S corporation shareholders that are non-grantor trusts or estates).
Partners and S corporation shareholders who make QEF or MTM elections would be required to notify the partnership or S corporation "in any reasonable manner" within 30 days of filing the return making the election. Failure to provide the notice would not invalidate the election.
QEF or MTM elections by domestic partnerships and S corporations before the proposed regulations are finalized will be deemed made by their partners and S corporation shareholders.
QEF inclusions require basis adjustments to avoid double taxation of the inclusions. The proposed regulations would provide the necessary basis adjustments for the partners/shareholders who have QEF inclusions. If the proposed regulations are finalized, domestic partners and S corporation shareholders would likely be able to obtain the necessary information to complete Form 8621 using the Schedules K-3 provided by the partnership or S corporation.
Treasury and the IRS request comments on whether the finalized regulations should continue to permit domestic partnership- and S corporation-level QEF and MTM elections on behalf of partners and shareholders.
Domestic non-grantor trusts and domestic estates will continue to be treated as entities for purposes of PFIC income inclusions and elections. Accordingly, a domestic non-grantor trust or estate may continue to make QEF and MTM elections.
A US Shareholder owning shares of a foreign corporation that is both a CFC and a PFIC is generally not subject to the PFIC rules under the CFC/PFIC overlap rule in IRC Section 1297(d). The proposed regulations would confirm this treatment by subjecting partners or shareholders to the PFIC regime if (1) their domestic partnership or S corporation owns a CFC that is also a PFIC; and (ii) they are not (indirect) US Shareholders of that CFC.
The proposed regulations that treat domestic partnerships and S corporations as aggregates for these PFIC purposes would apply to shareholders' tax years beginning on or after the date they are issued in final form.
Entity treatment for certain S corporations
After issuing final IRC Section 951A regulations, Treasury and the IRS issued Notice 2020-69 to help transition certain S corporations from entity to aggregate treatment for GILTI inclusion purposes. In certain circumstances, an S corporation may have an accumulated adjustments account (AAA) and accumulated earnings and profits (AE&P) of a C corporation predecessor. The aggregate approach may cause certain distributions by those S corporations to be considered taxable dividends from AE&P, rather than a non-taxable distribution from AAA even when shareholders have included subpart F or GILTI inclusions from CFCs owned by the S corporation.
Notice 2020-69 allowed certain S corporations to elect an entity-treatment rule to mitigate this result. Electing S corporations calculated a GILTI inclusion amount at the corporation level, and each shareholder of the S corporation had to include its distributive share of that amount in gross income, even if the shareholder itself was not a US Shareholder. The proposed regulations would adopt the election provided in Notice 2020-69 for qualifying S corporations and their shareholders that elect entity treatment for subpart F and GILTI inclusion purposes on an originally filed or amended return.
To qualify, an S corporation must have (i) made its S corporation election before June 22, 2019; (ii) been considered to own stock of a CFC within the meaning of IRC Section 958(a) on June 22, 2019; (iii) had an AE&P balance on September 1, 2020, or on the first day of any subsequent tax year; and iv) maintained sufficient records to support an AE&P determination. Once a qualifying S corporation electing entity treatment under the rule exhausted its AE&P balance, the S corporation would, like a domestic partnership, default to the aggregate treatment described previously.
The proposed rule to treat certain S corporations as entities for subpart F and GILTI inclusion purposes would apply to S corporation tax years ending on or after September 1, 2020. Furthermore, taxpayers may choose to apply the proposed rule to S corporation tax years ending on or after June 22, 2019, provided that the S corporation and its shareholders that are US Shareholders consistently apply the rules to all CFCs owned by the S corporation.
Proposed rules specific to NIIT
US individuals, trusts or estates that are considered to own PFIC stock or to be a US Shareholder of a CFC are not typically required to recognize a QEF, subpart F inclusion or GILTI inclusion amount currently for purposes of the NIIT imposed under IRC Section 1411. Rather, such taxpayers are subject to the NIIT only when there is a distribution from the foreign corporation or a capital gain on the shares of the foreign corporation. However, Treas. Reg. Section 1.1411-10(g) permits a taxpayer to make an election to accelerate the 3.8% tax on net investment income to the tax year in which such a deemed income inclusion is recognized, rather than wait for a liquidity event. Current rules require the election to accelerate income under the NIIT to be made at the entity level when the foreign corporation's stock is held through a domestic pass-through entity. The domestic pass-through owner may make the election only when the entity fails to do so.
The proposed PFIC regulations would terminate a domestic pass-through entity's ability to make an election under Treas. Reg. Section 1.1411-10(g) for the benefit of its domestic pass-through owners. Rather, the proposed PFIC regulations would generally only allow the election for the person whose tax liability is directly affected (i.e., the domestic pass-through owner). For qualifying S corporations that elect entity treatment under the proposed regulations, the election under Treas. Reg. Section 1.1411-10(g) may still be made by the S corporation; an S corporation shareholder in those instances could only make the election when the S corporation failed to do so.
This proposed rule would apply to tax years beginning on or after the rule is issued as a final regulation.
The final regulations and the proposed PFIC regulations merit careful study by any US partnership or S corporation that owns a 10%-or-more interest in a foreign corporation or any interest in a foreign corporation that might be a PFIC.
On the one hand, the final regulations treat domestic and foreign partnerships the same way for subpart F inclusion purposes and are consistent with the aggregate treatment of domestic partnerships for GILTI inclusion purposes. On the other hand, the final CFC regulations and (if adopted in final form) the proposed PFIC regulations will make compliance for domestic partnerships and S corporations owning stock in foreign corporations far more complex. It will not be possible for a domestic partnership or S corporation owning stock in a PFIC to say offhand whether it is subject to QEF or MTM treatment. That will depend upon what partners/shareholders do, and there is no a priori reason to expect that all partners/shareholders will make consistent elections.
There are also many unanswered questions about how this shift from entity-level treatment to partner-level treatment should be reflected in partnership capital accounts maintained in accordance with IRC Section 704, and how (if at all) they are to be reconciled with the "one class of stock" rules for S corporations. Finally, the proposed PFIC regulations would greatly increase the number of Form 8621s that would have to be filed.
Additionally, it will be risky for partners or S corporation shareholders in a partnership or S corporation that might own a PFIC to file their tax returns before the partnership or S corporation has completed its international tax analysis. Otherwise, they may lose the ability to make QEF/MTM elections, which must be made on a timely filed original return. Funds of funds in particular may not be able to complete their international tax analyses until very late in the compliance process. To alleviate such complexities, taxpayers should consider submitting comments recommending that Treasury and IRS allow domestic partnerships and S corporations to make QEF and MTM elections on behalf of their partners and shareholders. Comments on the proposed regulations must be received by April 25, 2022.
1 A discussion of how to attribute stock owned by a limited partnership to its partners is beyond the scope of this Alert.
2 Reg.Section 1.6038-2(j)(2)(i), 1.6046-1(e)(4)(iii), Instructions to Form 5471